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Hope Bancorp: Cheap Valuation Offers Significant Upside (NASDAQ:HOPE)

Investment thesis

Based in Los Angeles, California, Hope Bancorp, Inc. (TO HOPE) is a $17.2 billion asset holding company and the parent company of Bank of Hope. Interestingly enough, HOPE is actually the only large-scale community bank focused on Koreans and Americans. It has a fairly diverse set of loans with a clear focus on commercial real estate and SBA loans. It has offices all over the United States; specifically, branches are located in Alabama, California, Georgia, Illinois, New Jersey, New York, Texas, Virginia and Washington State, as well as an office in Seoul, Korea from South.

I fully understand why HOPE is trading at a discount to peer banks given its past credit issues. Most peer mid-sized community banks trade at 1.1 times price to tangible book value per share. As can be seen in the chart below, HOPE is currently trading at a 40% discount to this. My bullish stance on stocks is based on the fact that the current valuation is too low relative to its peers.

Basically, I think HOPE has built up its loan loss reserve enough to warrant a roughly peer-to-peer valuation. I think the credit profile urges people to be cautious, which I understand. However, my argument is that HOPE has already positioned itself to sustain above average losses. In my mind, the stock price should be much closer to its peers.

Data by Y-Charts

Revenue outlook

Second quarter spread revenue was $109.8 million, marking a decrease of approximately $10 million from the first quarter. Based on my analysis, I found that net interest margin (NIM) accounted for the entirety of the related quarterly decline. The second quarter reported NIM was 2.79% compared to the first quarter margin of 3.31%. Total loans increased by $275 million while deposits increased by $1.3 billion.

The substantial 52 basis point margin decline was caused by a multitude of things. First, and the most important reason, the average loan yield fell to 4.23% in the second quarter from 5.06% in the first quarter. The cost of interest-bearing deposits partially mitigated the painful reduction in loan yields, which fell more than 47 basis points in the same linked quarter. While it’s hard to see the effects in the last federal funds rate cut, HOPE has tried to remix its funding base into lower-yielding liabilities. I believe these efforts are likely to help the NIM move forward.

Second quarter fee income was $11.2 million. Although slightly lower than the $13.3 million recorded in the first quarter, total non-interest income was impacted by the negative effects of limited service charges. Also, the gain on the sale of a loan was down slightly, but that can be volatile in any given quarter.

Source: SEC Filings and author’s estimates

Based on my analysis of the balance sheet, I expect the margin to increase slightly from second quarter levels. The second quarter saw a fairly huge deposit build-up which was only used in cash. Even if management put it all in 10-year treasury bills, it would help the margin considerably and reduce some of the excess liquidity. From here, I expect the fourth quarter margin to improve over the third quarter results due to the cancellation of the PPP loan.

As we move forward into 2021, I expect the margin to be relatively stable from fourth quarter levels. HOPE is a fairly asset-sensitive bank, and I think the entire earnings-related asset portfolio should have been reviewed by the end of the year. I believe the current assessment assumes that these trough-like NIM levels will continue for the foreseeable future. If margin reports better than expected results and shows related quarterly improvement, I think stocks should trade higher after earnings.

Also, I think the overall fee income should increase at the end of the year. Even though it’s only about 10% of total revenue, I expect it to drift higher and return to pre-COVID levels by early 2021.

A dive into credit

Looking at the chart below, one can quickly understand that HOPE went through a very tough time during the last economic downturn. While most banks saw net charges (NCO) peaking at nearly 200 basis points, HOPE nearly doubled that amount during its darkest period.

However, and especially in my mind, from 2016 until today, the NCO set has been almost non-existent. During the second quarter, NCOs were only $0.65 million, or less than 0.02% of the entire loan portfolio. Even the first quarter, which was relatively high compared to the past two years, was only $3.4 million, or 0.11% of average loans.

Source: SEC Filings

Given what’s happened over the past two months, credit strength should be the first thing investors should be looking to find. If a bank has a solid track record and today’s credit profile continues to look strong, it’s easy enough to tick the box.

In the case of HOPE, the overall profile looks good today, but the bank has a disappointing history when it comes to NCOs. At the end of the second quarter, HOPE’s loan loss reserve stood at 1.26% of total loans. Although I would have liked this rate to be higher, I think the current rate is acceptable given the significant reduction in the loans criticized.

Source: SEC Filings

As can be seen in the graph above, not only have criticized loans continued to decline throughout this economic downturn, but the ratio of criticized loans to total loans (blue line) has also run even lower. As many of my followers can probably guess, I believe the most important ratio today is the criticized loan to reserve ratio (black line). Although slightly above my benchmark of 2.0x, I think the recent downward trend in critiqued loans, both in dollars and relative size, warrants a pass for the investment.

While I’m assuming third quarter results will likely prove limited NCOs, I think management will likely continue to have a high provision. This high provision will increase the level of reserves and further support the credit strength of the bank.

Conclusion

First, I fully understand why the stock is trading at a much lower valuation than peer banks. While recent credit trends should reassure investors, economic ups and downs have not been experienced during this period. It is difficult to change the credit culture in a bank; however, I fundamentally believe that HOPE has moved on from its poor underwriting credit history.

Although the bank may not be performing better than its peers in terms of credit problems, even if it has an “average” credit experience, the average bank is currently trading at almost 1.1 times the price per to tangible book value per share. In my mind, starting with the Q3 earnings release, if HOPE continues to prove limited NCOs, it should start trading higher. At the same time, if management adds to the reserve, it should give investors the confidence to re-enter the stock.

However, if the NCOs rise slightly, I don’t think the bank has much downside in the stock yet. The current valuation assumes a material deterioration in tangible book value per share, which I find highly unlikely.

Source: SEC Filings and author’s estimates